Trade finance’s paperless modernization gathers pace… slowly

By:
Solomon Teague
Published on:

Trade finance is renowned for its quaint reliance on paper documentation and relative lack of technological sophistication, but despite the pressure on IT budgets, the business is modernizing, albeit slowly.

The dematerialization of trade finance has been under way for years, though at a rather sedate pace.

It has been easy for banks to justify maintaining their traditional practices, partly to divert investment to higher-priority areas but also in response to the growing importance of emerging markets (EMs) in global trade.

“To date, EM corporates have been more reliant on documentary trade,” says Bertrand de Comminges, global trade advisory, HSBC.

This is ensuring traditional – some would argue, outdated – trade finance mechanisms, such as letters of credit, remain widely used, despite being paper intensive and relatively low-tech.

“Letters of credit have long been written off as an outdated instrument, but this business is very stable – it neither shrinks nor grows significantly and it survives every crisis,” says Daniel Schmand, head of trade finance and cash management corporates EMEA at Deutsche Bank.

Traditional and low-tech services might be best-suited to financing trade involving frontier markets. “Letters of credit historically have been the simplest way to finance deals, where there may be consignment issues, currency controls and other obstacles,” says Robert Dyckman, head of trade finance, Americas at BNY Mellon.

Many EMs, such as China, are rapidly modernizing, and the companies operating out of them are as sophisticated as any of their western competitors. Trade finance business with these companies is also modernizing, utilizing automation and electronic documentation.

These EM corporates are moving to open account relationships in increasing numbers. Such arrangements, which arise when two companies have a historic trade relationship that has generated a level of trust, are characterized by reduced risk and improved funding conditions.

“Their need for more traditional risk mitigation products from banks is being migrated to open account structures,” says HSBC’s De Comminges.

This creates a challenge for banks. Yet at the same time, the upheaval of the economic downturn has, perhaps paradoxically, reinvigorated the relationship between the bank and its clients.

“Since 2008, there has been a change of perception of trade finance solutions amongst clients,” says De Comminges. “As corporates have struggled to cope with increased volatility and the uncertainty involved in running global supply chains, it has encouraged greater appreciation of banks’ trade finance solutions.”

And as globalization drives corporates to do business in new markets, especially frontier markets, there will always be new trading relationships where bank intermediation is needed.

“Countries like China are moving towards open account relationships, but at the same time trade flows are moving to frontier markets like Bangladesh, Mongolia and parts of Africa, where letters of credit remain important,” says Schmand.

The challenge will be for the banks competing for the business in frontier markets. Arduous regulation is forcing banks to be more selective about the business they take on, as deals in certain locations become harder to justify from a cost-benefit analysis perspective, says Deutsche’s Schmand.

This might eventually lead to the increasing prevalence of new institutions in the trade finance business. Banks based in jurisdictions with less arduous regulation have a clear advantage and might be in a position to capitalize and increase their market share in trade finance, adds Schmand.

The barriers to entry in trade finance are relatively low, given the relatively basic technology systems the business uses. And this is not only because many companies using trade finance are themselves using paper-based systems: there is less pressure on trade finance to push through technology investment, says Schmand, because the business is dominated by a relatively small number of large transactions.

“Some parts of the bank execute 100,000 trades a minute and it is obvious the best technology systems are needed to handle that,” he says. Trade finance tends to measure its transactions in tens per day, not thousands per minute, he adds.

“Trade finance does see less technology investment than other parts of the bank, but there is less need for investment than on the cash-management or securities sides of the business,” says Schmand. “Less investment is not the same as underinvestment.”

Trade finance can be innovative, but usually in how deals are structured rather than at the product level, adds Schmand.

There does, therefore, remain a place in trade finance for traditional forms of financing that might seem clunky and old fashioned to some, compared with the algorithmic trading systems and high-tech risk-management systems employed in other areas of the bank.

Letters of credit, a perfect example, are too useful to become extinct as a part of trade financing, says BNY Mellon’s Dyckman. “They will remain the default choice for many people who are more comfortable using them.

“Whenever two trading partners are wary of each other, there will always be demand for letters of credit. It is the process behind them that will change, as is already happening.”